Part 4: My concerns about financial reporting standards for the public sector

The Auditor-General’s views on setting financial reporting standards for the public sector.

4.1
I have been concerned for some time about the effects of IFRS on the setting of financial reporting standards in New Zealand, especially as it affects the public sector. In my view, too much focus on the process for standard setting has overtaken what should be the aim of standard setting. The aim should be high-quality standards designed to produce general purpose financial reports that are understandable and can be used to properly hold public sector entities to account.

4.2
In this Part, I comment on the role of general purpose financial reports, set out my general and specific concerns about the suitability of NZ IFRS for the public sector, and raise questions about the suitability of NZ IFRS in the future.

The role of general purpose financial reports

4.3
Many people using financial and non-financial reports are not in a position to demand information that is designed specifically for their needs. However, although specific information needs cannot be met, there are typically common information needs that arise for many different people about the resources of an entity and how those resources have been used. General purpose financial reports are reports that contain financial and non-financial information that is designed to meet the common information needs of a wide range of people.

4.4
Financial reporting standards govern how general purpose financial reports are prepared. The people who use general purpose financial reports rely on the standard setter to establish reporting requirements that are relevant to the variety of entities covered by the standards. Setting standards relevant to different types of entities requires a good appreciation of the range of information needs of people using different entities' financial statements.

4.5
In my view, the information needs of people who use general purpose financial reports in the public sector are quite different from those in the private sector. In the public sector, the primary objective of general purpose financial reporting is to provide information to ensure that entities are able to meet their accountability obligations to Parliament and the public. Entities must account, and must be seen to account, for their use and stewardship of public resources in the delivery of goods and services to the community.

4.6
In my view, information in general purpose financial reports of public sector entities should have at least the following important attributes:

the performance of the entity can be clearly understood in the context of what the entity is trying to achieve;
the financial performance of the entity makes sense when related to its non-financial performance;
the entity's performance can be readily compared with the plans of the entity at the start of the reporting period;
the stewardship of the entity can be readily assessed by reference to the entity's balance sheet and supporting notes; and
the entity's long-term sustainability can be assessed.

4.7
Implicit in ensuring that information in public sector entities' general purpose financial reports is useful to people is an acknowledgement that those reports do have limitations. In other words, general purpose financial reports cannot be expected to meet all the information needs of everyone. Rather, a sensible balance needs to be struck between not overloading people with information but at the same time providing important information with which entities can meet their accountability to the public.

4.8
I realise it is difficult to establish exactly what information should or should not be in general purpose financial reports for public sector entities. I have some ideas about the sorts of information people need in order to hold public sector entities to account. Many of my views expressed in this discussion paper will, I hope, provide some insights into the sort of information I consider is needed. However, I do not have all the answers.

4.9
As noted in paragraph 4.4, to set relevant and appropriate financial reporting standards requires a clear understanding of the needs of people who use public sector entities' general purpose financial reports. I do not think there is a widely accepted clear understanding in New Zealand. In my view, more work needs to be done on establishing that clear understanding, as well as getting general consensus about what that kind of understanding entails.

4.10
I anticipate that, if done well, the International Public Sector Accounting Standard Board's work on a public sector conceptual framework could help shape the information that would be included in public sector entities' general purpose financial reports. However, this is unlikely to provide all the answers for New Zealand.

General concerns about the suitability of NZ IFRS for the public sector

4.11
In Part 2, I expressed concerns about the process for adapting IFRS to NZ IFRS. Further to those concerns, I have some general concerns about the suitability of NZ IFRS for the public sector.

4.12
These general concerns can be grouped into two broad categories:

the complexity of the requirements in NZ IFRS for all reporting entities in the public sector, particularly smaller entities; and
the difficulty associated with applying many of the requirements in NZ IFRS for public benefit entities.

4.13
In my view, NZ IFRS have introduced a new and unnecessary level of complexity to general purpose financial reporting. As a result, many public sector entities now need external assistance to prepare their financial reports. Also, anecdotally, members of governing bodies and other people who use financial statements are finding it increasingly difficult to understand the information.

4.14
Increasing complexity is now evident to varying degrees in all aspects of financial reporting (that is, recognition, measurement, presentation, and disclosure). In my opinion, based on proposals currently being worked on and those that are planned, complexity is only likely to increase.

4.15
In my view, the process for setting standards is not focused enough on assessing the costs and benefits for different types of entities. Generally, a "one size fits all" approach is being taken to setting standards. The approach appears to be "if large companies have to do it, all entities can do it".

4.16
The differential reporting regime within generally accepted accounting practice is designed to ease the compliance burden on smaller reporting entities. Although this has helped financial reporting by smaller public sector entities, in my view the current differential reporting concessions do not go far enough. The concessions do not make a big enough difference between full compliance with generally accepted accounting practice and compliance with the differential reporting regime.

4.17
In my view, smaller entities need further concessions regarding recognition and measurement requirements, as well as presentation and disclosure.

4.18
For accountability to be properly served in the public sector, general purpose financial reports need to be understandable for a wide range of people. Reports that are not understandable undermine public sector accountability.

4.19
IFRS have been built on several fundamental premises that, mainly, do not apply to public benefit entities in New Zealand. The premises are that:

entities have an overriding profit-seeking objective;
transactions are invariably exchange¹ in nature;
markets exist for these transactions to take place;
asset values are largely arrived at by referring to future cashflows; and
the main people using general purpose financial reports are investors, analysts, and regulators.

4.20
In my view, it is not surprising that standards built on these premises are not automatically suitable for the public sector. Such standards will not be readily transferable to public benefit entities unless enough amendments are made (including additional guidance for public benefit entities that takes account of the circumstances in which those entities operate and transactions common to those entities).

4.21
The contrast between the fundamental premises noted in paragraph 4.19 and how they might apply to public benefit entities is stark, as Figure 1 shows.

Figure 1
Applicability of IFRS premises to public benefit entities

Fundamental premise of IFRS	Applicability to public benefit entities
Entities have an overriding profit-seeking objective.	Public benefit entities have an overall objective of providing goods and services for community or social benefit.
Transactions are invariably exchange in nature.	Many of the transactions of public benefit entities are non-exchange in nature.
Markets exist for these transactions to take place.	Markets often do not exist. Public benefit entities hold many specialised assets and have obligations that cannot be readily transferred to third parties.
Asset values are largely arrived at by referring to future cashflows.	An assessment of value needs to take account of the nature and purpose of the entity (that is, to deliver future services to the community) rather than cashflows.
The main people using general purpose financial reports are investors, analysts, and regulators.	The main people using general purpose financial reports are Parliament and the public.

4.22
Another concern is that some governing bodies are now choosing to publicly denounce the use of NZ IFRS for their financial statements. I have seen comments such as:

"provides neither a meaningful statement of performance nor a true and fair view of the statement of financial position";
"the new rules unquestionably distort reported results and make the accounts more difficult for the average reader to understand"; and
"while IFRS requires us to adopt these values, they are largely illusory and do not reflect the reality".

4.23
Although I do not fully agree with the way all of these comments are expressed, in my view, there are some real issues underlying the comments. Furthermore, irrespective of the actual comments, I am concerned when governing bodies feel the need to comment publicly that financial reporting standards based on IFRS are not leading to financial statements that are “fit for purpose”.

Specific concerns about the suitability of NZ IFRS for the public sector

4.24
In paragraphs 4.26–4.88, I discuss some specific issues that lead me to question the suitability of requirements in NZ IFRS. I am also aware that with the pace of new requirements from the International Accounting Standards Board and the complexity already in IFRS, new issues will continue emerging.

4.25
I wrote to the Accounting Standards Review Board in March 2009 setting out most of these specific issues. My letter was in response to a request by the new chairman of the Accounting Standards Review Board to elaborate on my main concerns with NZ IFRS.

The language used is too focused on the private sector

4.26
The language pervading NZ IFRS is a major concern to me. That language, as one would expect of IFRS, focuses on profit-oriented entities. Little or no change has been made between IFRS and NZ IFRS to make the language more appropriate to a wider variety of entities. All too often, in my view, this means that the standards are hard to read and not particularly relevant to the circumstances faced by public benefit entities.

4.27
Difficulties with the language can make it harder for public benefit entities to apply the standards. It is harder because a mindset is needed where some of the words need to be subconsciously replaced with words that make sense in a public benefit entity context. The need for such a mindset affects the suitability of the standards because they are more difficult to understand in a public benefit entity context and more open to interpretation. Also, it is not always easy for those having to apply the standards to switch into that necessary mindset.

4.28
In my view, the issue of inappropriate language could have been lessened, to some extent, by including guidance or interpretation in NZ IFRS for public benefit entities. However, even though IFRS include a lot of guidance and interpretation for circumstances and transactions common to profit-oriented entities, there has been little such guidance or interpretation added to NZ IFRS for public benefit entities. I expect that my Office will have to make up for these deficiencies by providing guidance or interpretation for public benefit entities in the public sector.

4.29
I am concerned that my Office may need to provide guidance or interpretation in order for NZ IFRS to be fit for purpose in the public sector. My concerns are twofold:

providing guidance and interpretation is more properly the job of the Financial Reporting Standards Board; and
such a role is not ideal, given my statutory and professional obligations to remain independent.

The reporting of some public sector restructuring is misleading

4.30
I am concerned that financial reporting standards include inappropriate requirements for certain types of restructuring that can arise in the public sector. Those financial reporting standards are NZ IFRS 3 and the revised version of that standard.²

4.31
The scope of NZ IFRS 3 excludes restructuring situations involving entities or businesses that are controlled ultimately by the same party. This exclusion means that many of the types of restructuring common in the public sector (for example, the amalgamation of two entities controlled by the Crown) are sensibly excluded from the scope of the standard.

4.32
However, there are other types of restructuring that occur in the public sector that are not excluded from the scope of the standard. For example, the combining of two or more local authorities by an Act of Parliament, or by mutual agreement, would be within the scope of NZ IFRS 3.

4.33
Being within the scope of the standard means that purchase accounting must be applied to the restructuring. Purchase accounting requires one entity to be identified as the acquirer, and that entity acquires the other entity or entities. The fair value of the assets and liabilities of the acquired entity or entities must be calculated and accounted for. The difference between the fair value of net assets and the amount the acquirer pays for the entity or entities must also be accounted for.

4.34
In my view, purchase accounting is inappropriate in a restructuring situation such as when two or more local authorities combine. It does not make sense for one local authority to pay to acquire another local authority. Therefore, the entire fair value of the assets and liabilities of the local authority acquired would be recognised as a gain in the income statement of the local authority that is identified as the acquirer.

4.35
In my view, such accounting is a nonsense because it would give rise to misleading reporting. It would not reflect the substance of the restructuring taking place. I also have concerns about the costs of this requirement for what I see as no (or negative) benefit.

4.36
The scope of NZ IFRS 3 (revised) is similar to NZ IFRS 3. The revised standard requires the acquisition method to be used to account for restructuring. That method is very similar to purchase accounting. For restructuring such as the combining of two local authorities, the application of the revised standard would also give rise to reporting that is misleading because it would not reflect the substance of the restructuring taking place.

4.37
I acknowledge that my concern set out here was also a concern under previous standards. I am told that the Financial Reporting Standards Board thought specifically about the matter before issuing NZ IFRS 3 and NZ IFRS 3 (revised). If that is right, I do not understand why the Financial Reporting Standards Board decided against changing the standards for public benefit entities. However, I am aware that the Financial Reporting Standards Board now intends to reconsider this matter.

It is unclear which entities to include in a public sector group

4.38
I am concerned that the current requirements for group financial statements of public benefit entities are not clear. Those requirements are set out in the accounting standard NZ IAS 27.

4.39
The issue of group financial statements is an important issue for the public sector. Group financial statements have an effect on the transparency of reporting and accountability of many public sector entities, because they provide a picture of the combined available resources of, and use of those resources by, a "parent" entity.

4.40
The notion of "control" has been used for many years to decide which entities are consolidated into a group reporting entity. That notion has a difficult history in the public sector.

4.41
Before NZ IFRS, FRS-37 was the applicable financial reporting standard for group financial statements. FRS-37 was designed to address the application difficulties encountered in the public sector.

4.42
When NZ IAS 27 was being prepared, certain requirements and guidance from FRS-37 about control were kept for public benefit entities. The requirements and guidance were kept for public benefit entities by way of a cross-reference in NZ IAS 27 to parts of FRS-37.

4.43
There are different interpretations about what the cross-reference to parts of FRS-37 means. One interpretation is that the cross-referenced parts are only used to the extent that they are consistent with NZ IAS 27. Another interpretation is that those parts must be used to ensure that public benefit entities can appropriately apply NZ IAS 27. In my view, the second interpretation aligns with the intention of including the cross-reference. I consider the cross-referencing approach was a pragmatic response of the Financial Reporting Standards Board to avoid the need to make major changes to NZ IAS 27.

4.44
In addition to being open to interpretation, I am also concerned about proposed changes to NZ IAS 27. A proposed replacement standard for profit-oriented entities (referred to as exposure draft 10, or ED 10) was issued for comment by both the International Accounting Standards Board and the Financial Reporting Standards Board at the end of 2008. Although the Financial Reporting Standards Board has signalled its intention to take into account public benefit entity issues associated with ED 10, proposed changes or additions for public benefit entities have not yet been issued for comment.

4.45
In my view, significant changes for public benefit entities will need to be made to the proposed replacement standard based on ED 10. However, given the Financial Reporting Standards Board's general reluctance to make changes to NZ IFRS for public benefit entities, the replacement standard does not bode well for the public sector.

4.46
In my view, the most relevant accounting requirements to group financial statements of public benefit entities currently are those requirements in FRS-37. I do not want to imply that FRS-37 is ideal. However, of the material currently available, I consider FRS-37 best focuses on the substance of arrangements often found in the public sector. By substance, I mean where an entity has been able to secure and protect benefits from the activities of another entity, even if the first entity does not direct the day-to-day operations of the other entity.

4.47
I am concerned that the Financial Reporting Standards Board is planning to remove the FRS-37 requirements and guidance about control from NZ IFRS without having yet provided a suitable alternative for public benefit entities.

Typical public sector financial transactions are not adequately addressed

4.48
It is widely accepted that standards for financial instruments are the single biggest change in financial reporting resulting from NZ IFRS. Financial instruments include both financial assets (such as receivables) and financial liabilities (such as loans). Almost all reporting entities, including those in the public sector, have some form of financial instruments.

4.49
The bigger changes to financial reporting resulting from the standards for financial instruments are:

recognition of all derivatives (such as interest rate swaps) on the balance sheet rather than disclosed in notes to the financial statements;
recognition of financial guarantees on the balance sheet rather than disclosed in notes to the financial statements; and
initial recognition of all financial assets and financial liabilities at fair value.

4.50
Under NZ IFRS, there are three standards covering recognition, measurement, presentation, and disclosure of financial instruments. Those standards are NZ IAS 32, NZ IAS 39, and NZ IFRS 7. Before NZ IFRS, there was only one standard on financial instruments covering disclosure requirements.

4.51
The financial instruments standards (which affect most reporting entities) contain no changes from the requirements of the IFRS, and no additional guidance for circumstances and transactions common to public benefit entities. I presume there are no changes or guidance because the Financial Reporting Standards Board considers that any differences between financial instruments in the public and private sectors do not warrant changes or guidance. However, in my view, there are some significant differences in the public sector that do warrant changes to requirements and additional guidance for public benefit entities.

4.52
The financial instruments standards do not adequately address common types of financial transactions found in the public sector, including:

levying taxes, rates, and fines through use of legislative powers;
granting or receiving concessionary loans; and
providing financial guarantees in a non-exchange context (for example, the Government Deposit Guarantee scheme).

4.53
The three standards tend to be either irrelevant to the transactions (for example, the Crown accounting for sovereign receivables such as tax and fine receivables) or difficult to apply to the transactions. There can be difficulties applying the standards in practice because the nature of transactions typically found in the public sector are not the type of transactions envisaged by the International Accounting Standards Board when they established the standards.

4.54
In some instances, the financial instruments are complex and therefore difficult to account for. Complexity and accounting difficulties arise particularly when the substance of a financial instrument differs from the form of the arrangement. For example, public sector suspensory loans are often documented as liabilities but, in substance, are equity contributions.

4.55
I am also concerned about the effects on public sector entities of the current disclosure requirements associated with NZ IFRS 7. Public sector entities have needed to create new systems and processes to capture the information that now needs to be disclosed, despite the lack of any assessment of the value of such disclosures for those using the information in the financial statements. Also, the value of potentially more relevant disclosures for people using public sector entities' financial statements has not been properly assessed.

4.56
The underlying assumption of the Financial Reporting Standards Board seems to have been that if it is a disclosure requirement in IFRS, it should also be a disclosure requirement in NZ IFRS. That assumption does not take into account differences in the information needs of people using public sector entities' financial statements. The main people using private sector financial statements are investors, analysts, and regulators. In the public sector, the main users are Parliament and the public.

4.57
I consider that if the standards for financial instruments were looked at from a complexity, appropriateness, and cost-benefit perspective for people using financial statements, amendments would be warranted.

Public sector insurance liabilities are required to be conservatively calculated

4.58
The financial reporting standard for insurance (NZ IFRS 4) applies equally to private sector and public sector insurers.

4.59
NZ IFRS 4 requires insurers to calculate a liability for all outstanding claims and for that calculation to include a "risk margin". The risk margin means the liability for outstanding claims includes an amount above the estimated cost of settling the claims, based on a mid-point estimate. Rather than taking an approach of using a mid-point estimate, a more conservative estimate is required by the standard.

4.60
To me, it appears the rationale for increasing the liability above the mid-point estimate is to arrive at an amount a third party is likely to want to be paid to assume the risk of settling the claims. Such an amount is referred to as an exit value.

4.61
There are no exemptions for public benefit entities from the requirement to include a risk margin. Nor is there any guidance about the application of this requirement for public benefit entities.

4.62
In the public sector, the Accident Compensation Corporation (ACC) is the entity most affected by the requirements in NZ IFRS 4. Because ACC has incorporated a risk margin, about $2 billion has been added to its outstanding claims liability. That $2 billion is over and above the mid-point estimate of the amount that would be expected to be paid out in claims and is therefore an inherently conservative estimate of the outstanding claims liability.

4.63
Although funding issues can be distinguished from accounting treatment, in my view the risk margin requirement raises some important issues in the public sector:

If public sector insurers such as ACC set levies and other funding requirements based on a liability that includes the risk margin, they are likely to recover levies and other funds at an amount over and above what they expect to pay out in claims.
If, on the other hand, public sector insurers such as ACC set levies and other funding requirements based on a liability excluding the risk margin, it calls into question the relevance and usefulness of the liability figure required to be recognised in their financial statements.

4.64
I am told that in the case of ACC, levies and other funding is currently calculated using a mixture of both approaches: one for claims funded by levies (that includes the risk margin), and one for claims funded by the Crown (that excludes it).

4.65
Either way, I consider there are concerns about the requirement for inclusion of a risk margin in the public sector environment – exit value is seldom appropriate, except perhaps for assets and liabilities actively traded.

The required disclosures for related-party transactions are unclear

4.66
The disclosure of relevant related-party information is a critical element of accountability in the public sector. Disclosure is critical because transactions between related parties may not be made at the same amounts as they would be if the parties were unrelated.

4.67
Such information includes transactions between related entities and also transactions involving the people who govern and manage an entity. The latter group of transactions is particularly challenging in the public sector given the complex constitutional principles in place, particularly between Ministers and government departments.

4.68
NZ IAS 24 is the standard that sets out the related-party transaction disclosures required by reporting entities. NZ IAS 24 includes an exemption for public benefit entities that is designed to eliminate the need for unnecessary disclosure of routine related-party transactions between public sector entities. For example, the exemption means a public benefit entity in the public sector purchasing stamps from New Zealand Post, or paying ACC levies, does not need to make disclosures about the transactions.

4.69
The Financial Reporting Standards Board has been working for some time on improving the wording of an exemption for public benefit entities from certain disclosures. Also recently, the International Accounting Standards Board has released a draft proposal to reduce unnecessary disclosure of transactions with the State in the ordinary course of business.

4.70
Although I welcome initiatives to eliminate unnecessary disclosures, in my view more work is required by the Financial Reporting Standards Board to adequately deal with the issues. The Board needs to strike the right balance between:

not requiring disclosure of information that does not materially affect the accountability of public sector entities; and
requiring disclosure of information that is of likely interest to Parliament and the public, and that materially affects the accountability of public sector entities.

4.71
I have particular concerns about the disclosures required by public sector entities relating to transactions involving people who govern or manage an entity (or their close family members). The requirements for disclosure of these transactions are not clear and are open to interpretation.

4.72
I support the old adage that "sunlight is the best disinfectant". In other words, I generally favour disclosure over non-disclosure of such transactions.

4.73
However, the standard currently requires disclosure of all transactions between a public sector entity and another party, where the party is a close family member of those in governance or management (for example, the employment of the spouse or child of a Minister of the Crown by a public sector entity).

4.74
In my view, the intent of requiring such disclosures is to capture transactions that are only entered into because the parties are related, and hence there is an increased risk of pecuniary benefit to the individual or the close family member. Therefore, in cases where a transaction takes place because of the related-party relationship, it is entirely appropriate to require full disclosure of the nature of the transaction.

4.75
However, where transactions are carried out without regard to, or influence from, related-party relationships, there is a risk that disclosure of transactions theoretically caught by the standard will be both unwieldy and of little use to people; for example, disclosure in the financial statements of the Government of all transactions involving close family members of Ministers with any public sector entity within the Crown.

4.76
Overall, in my view, the requirements governing disclosure of related-party transactions are not clear. Proposals to change these requirements, although well intentioned, are confusing and do not go far enough. Further work is needed, particularly in the area of disclosure of transactions involving individuals who are members of the governance or management of an entity (or close family members of those individuals).

The calculation of sick leave liabilities is costly and unclear

4.77
Until the adoption of NZ IFRS, New Zealand did not have a financial reporting standard that dealt with employee benefits. Despite not having a standard, most entities in the public sector accounted for employee benefits such as long-service leave and retiring leave.

4.78
NZ IAS 19 is a standard about employee benefits that was adopted as part of NZ IFRS. That standard confirms much of the accounting for employee benefits that had been carried out earlier. However, NZ IAS 19 also requires the accounting of sick leave liabilities in certain circumstances.

4.79
The recognition of sick leave liabilities stems from an underlying principle of NZ IAS 19: that a liability needs to be recognised when an employee has provided service in exchange for benefits to be paid in the future. Although sick leave affects all sectors, the nature of sick leave entitlements in the public sector typically makes it more significant than in other sectors.

4.80
A lot of cost and effort has gone in, and continues to go in, to applying NZ IAS 19 to sick leave benefit schemes in the public sector. Much of the cost arises because entities engage actuaries to calculate sick leave liabilities. I am concerned that the cost and effort is out of proportion to any benefit to be derived from calculating sick leave liabilities.

4.81
There are different interpretations about how NZ IAS 19 should be applied to some sick leave benefit schemes. Further, the interpretations result in significantly different sick leave liabilities. I am concerned that significant differences can arise in the amount of sick leave liabilities by applying the standard.

4.82
I am also aware that counter-intuitive outcomes can arise from applying the standard. For instance, some entities' sick leave benefit schemes periodically allocate a certain number of paid sick leave days to employees. Sick leave days not used can usually be carried forward into one or more future years. Other entities have wellness schemes where there is no allocation of “paid” sick leave days. These schemes work on the basis that sick leave is taken as needed and there is no specified maximum number of days in a period.

4.83
Applying NZ IAS 19 to the two schemes outlined above results in the recognition of a liability in the first instance but not in the second. The reason for the difference is technical, but relates to the underlying principle of NZ IAS 19. Nevertheless, I am concerned that financial statements will show a picture that, in some instances, is counter-intuitive to people using financial statements.

There has been a protracted debate over accounting for borrowing costs

4.84
In May 2007, the Financial Reporting Standards Board decided to eliminate the option for public benefit entities to record borrowing costs as an expense when they are associated with the construction of assets. The Accounting Standards Review Board approved the revised standard that incorporated that decision.

4.85
Since August 2007, I have been actively lobbying the Accounting Standards Review Board to withdraw its approval for the standard on borrowing costs (NZ IAS 23) unless the Financial Reporting Standards Board reinstates the option for public benefit entities to record such costs as an expense.³ I have been lobbying because I consider that it is not appropriate to require compulsory capitalisation of borrowing costs.

4.86
I have several concerns about the elimination of the expense option and therefore the compulsory capitalisation of borrowing costs on construction projects. I am concerned that:

capitalisation of general borrowings in the public sector is both complicated and arbitrary, and therefore unlikely to enhance the reliability of general purpose financial reports;
there is no clear way to incorporate a component for borrowing costs into revaluations of most significant public sector assets, which is likely to make asset revaluations less reliable; and
any benefits of capitalising borrowing costs are significantly outweighed by the compliance costs of initial capitalisation and subsequent revaluation of assets.

4.87
In November 2008, the Financial Reporting Standards Board submitted a standard to the Accounting Standards Review Board for approval that reinstated the option for public benefit entities to record borrowing costs as an expense rather than to require compulsory capitalisation of such costs. That standard was approved by the Accounting Standards Review Board. I was pleased to see the option reinstated, given the concerns associated with compulsory capitalisation noted above. However, getting the option reinstated for public benefit entities took 18 months of active lobbying from my Office.

4.88
The effort it took to get the option reinstated reinforced for me that fundamental change is needed to standard setting for the public sector. My Office cannot afford to devote the sort of resources that were necessary in this case to other major areas of concern to get common sense to prevail.

Other concerns

4.89
There are other issues in standards currently in force that I am concerned about. In my view, these other issues, although important, are secondary to those set out in paragraphs 4.26–4.88. Details of some other issues are included in Appendix 2.

Questions about the suitability of NZ IFRS for the public sector in future

4.90
In addition to my concerns with existing financial reporting standards, I am also concerned about several important changes that are happening internationally. These call into question the suitability of IFRS as a base for standards in New Zealand. In my view, it will become increasingly difficult for New Zealand to continue with the approach of NZ IFRS applying to all reporting entities, including public benefit entities. Even if the Financial Reporting Standards Board became amenable to making greater changes to NZ IFRS for public benefit entities, I still foresee problems with its suitability for those entities.

4.91
In my view, the changes happening internationally make it inevitable that, within the next few years, financial reporting standards will need to be more clearly separated. This is likely to mean that standards applying to selected profit-oriented entities will need separation from standards applying to public-benefit and other entities.

Two distinct international conceptual frameworks arising

4.92
There are two international projects under way that relate to the conceptual frameworks that underpin general purpose financial reporting. The International Accounting Standards Board is working on a project in conjunction with the United States Financial Accounting Standards Board (for the private sector), and the International Public Sector Accounting Standards Board has its own project (for the public sector). See Part 3 for more information about these projects.

4.93
These projects look likely to result in different approaches to what are fundamental matters in general purpose financial reporting. It looks as though there could be differences in the objectives and scope of general purpose financial reporting as well as in the definition of the most important components of financial statements, such as assets and liabilities.

4.94
To be useful, any conceptual framework needs to be relevant to the range of reporting entities covered by the financial reporting standards. The current situation means New Zealand needs a conceptual framework that adequately covers both profit-oriented entities and public benefit entities.

4.95
I expect the Financial Reporting Standards Board will have a significant challenge putting in place one appropriate conceptual framework for all entities. The challenge will be greater given the likelihood that the two international conceptual frameworks will continue to diverge rather than converge. Based on experience to date,⁴ I expect the New Zealand framework will continue to be heavily based on the International Accounting Standards Board framework. That latter framework focuses solely on profit-oriented entities, with little regard for the different nature of public benefit entities as reflected in the International Public Sector Accounting Standards Board's work on its public sector conceptual framework.

4.96
In my view, having a New Zealand conceptual framework heavily based on the International Accounting Standards Board's revised conceptual framework would add to the existing general unsuitability of NZ IFRS for public benefit entities.

Redefining of liabilities likely

4.103
The International Accounting Standards Board has almost completed a project to change its standard on provisions, contingent liabilities, and contingent assets. That standard is IAS 37. Currently, provisions are recognised on the balance sheet when payment in the future is probable (that is, payment is more likely than not) to meet obligations.

4.104
The International Accounting Standards Board's proposals will move the notion of "probability" from the recognition criteria into the measurement of a provision. The result of the proposal will be the recognition of provisions on the balance sheet when payment is not probable. The International Accounting Standards Board's proposals will require provisions to be recognised for items currently disclosed as contingent liabilities in a note to the financial statements. Recognition will be required even if the probability of occurrence is not likely (for example, even if there is only a 10% chance of occurrence).

4.105
Apart from the measurement difficulties associated with the International Accounting Standards Board's proposals, and questions about the reliability of information, I would question the relevance of this approach in the public sector environment. Public sector obligations can seldom be settled by transferring them to third parties, as can occur in the private sector.

4.106
I understand the International Accounting Standards Board aims to issue its new liabilities standard before the end of 2009. I am concerned that the requirements of the new standard may be applied to public benefit entities in New Zealand, despite these difficulties and questions.

Concluding comments

4.107
Although some of the issues raised in this Part could be properly addressed by the Financial Reporting Standards Board, others are more systemic. The systemic issues are likely to remain problems as long as the approach in New Zealand is to apply NZ IFRS to all types of reporting entities, with minimal change for public benefit entities.

4.108
There are some current initiatives that provide an ideal opportunity to address issues with the suitability of standards based on IFRS for the public sector. I am aware of the review of the financial reporting framework being led by the Ministry of Economic Development. And I am also aware of the Accounting Standards Review Board's associated work to broadly set out the nature of reporting within the various reporting tiers in the framework.

1: Exchange transactions are transactions involving two parties, a buyer and a seller, who agree to an exchange of approximately equal value. For example, exchange transactions include the sale of goods for cash or the provision of services for cash.

2: NZ IFRS 3 (revised) was gazetted in February 2008 for application in periods beginning on or after 1 July 2009.

3: The Accounting Standards Review Board's powers are limited to approval or withdrawing approval of financial reporting standards submitted to it.

4: The current NZ Framework is based on the International Accounting Standards Board Framework with some additional paragraphs. I was led to believe the additional paragraphs were a holding position and that the Financial Reporting Standards Board was going to revisit the framework in 2005. No such review has taken place as far as I am aware.

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